How to leverage fear with confidence

Stock market volatility is synonymous to the changing of the seasons where summer follows spring, fall follows summer, winter follows fall. This cycle is repeated over and over like clockwork. Volatility in the market also goes through periods of boom and bust. Periods of vigorous price changes are interspersed with those of relative calm.

The stock market is in a constant state of flux, when one moment it seems that the market is dull and lifeless only to be followed by periods of explosive activity. Often, traders are caught off-guard. By the time they regain their bearings, the opportunity is over. Truthfully, even when the opportunity is recognized, most investors choke and fail to act when the market moves fast. They’re left sitting on the sidelines, afraid to throw their money into the action.

This failure to act can end up costing individual investors dearly. A 2011 study from Dalbar, a Boston-based research firm, estimated that stock investors as a group achieved a meager 3.8% annual return from Dec. 31, 1990, to Dec. 31, 2010, vs. the market’s 9.1% annual average return over that period.

The reason is over that 20-year period, investors jumped in and out of the market at the worst moments. When they should have been buying, they sold out of fear. When they should have been selling, they bought out of greed. The lesson is that your emotions can work against you. If you trade with no plan or strategy to capitalize on the days that offer the best chance for returns, you will leave money on the table, or worse, be on the wrong side of the market at the worst time.

Fortunately, traders can rely on an indicator that is highly correlated to stock market volatility — one that is even more accurate at this task than price itself. First, though, we should lay a foundation of understanding, so it will be clear how to profit from its application.